Tuesday, October 22, 2013

In my haste to get this blog up and running, I made a pretty glaring omission to my earlier blog post about the shut down of the Silk Road. My post noted that contrary to my expectations, the trade price of Bitcoin only briefly dipped after the shut down of the Silk Road, and rallied very strongly shortly after. I mentioned two reasons for this:

1. The average Bitcoin investor has matured compared to previous booms and busts, lessening the severity of panic sell-offs.2. Alternatives to the Silk Road are emerging that may absorb the black market demand, preserving the transactional value of Bitcoin.

I still think these factors played a role in Bitcoin's stability throughout the post-Road period, but I forgot to mention the most obvious reason: Bitcoin users have enough faith in its legitimate uses that they're not worried about the shutdown of a shady website. (There are two other major events that occurred during this time period: The US almost defaulting on it's debt, and promotion of Bitcoin in China, I will discuss these further down)

The chart above shows what the price of Bitcoin looked like since the Silk Road shutdown. The initial downward kink is about when the news started to spread about the site's shutdown. As you can see, Bitcoin has rallied incredibly since then. (Note that the prices are for campbx.com, a smaller exchange where prices tend to be a bit lower. Today on bigger exchanges prices are averaging around $199 per coin). My interpretation of this meteoric rally and then some is that in the eyes of many Bitcoin users,the Silk Road shutdown is good for the currency.

One reason for this is that at least for now, the regulatory heat is off Bitcoin. It will heat up again, of that I'm sure, but the impetus to go after Bitcoin has definitely eroded at least a little bit, now that the major market that facilitated hundreds of millions worth of illegal transactions is gone. Most politicians who voiced concern over Bitcoin (Schumer comes to mind) did so specifically because of its black market applications. As I noted in my other post, alternative black markets will spring up and reignite the regulatory discussions, but at least for now we have a brief respite from panic-cries of the uninformed.

Now, the appeal of Bitcoin for illegal activity is fairly obvious. Bitcoin allows a savvy enough user to basically send money anywhere in the world within minutes anonymously. While every Bitcoin transaction is recorded in a ledger called the blockchain, it's fairly difficult to associate ownership of an address by a human being.

So you may be wondering what the appeal of Bitcoin is for the typical, law-abiding citizens. I noted in my Google Plus post on April 4th that BitPay, an independent Bitcoin payment processorhad eclipsed The Silk Road in terms of dollars worth of Bitcoin processed for the month of March 2013. BitPay is a completely above-ground registered business, that at least claims to only deal with other legitimate businesses.

This meant that even as far back as March, Bitcoin was beginning to shed its (in my opinion erroneous) association with illegal activity. BitPay's solutions allowed merchants, even those who didn't really understand Bitcoin, to accept Bitcoin for payments, and immediately receive cash from BitPay. For their service, BitPay charged much lower transaction fees than just about any credit-card company in existence.

And BitPay aren't the only option for merchants looking to take advantage of the emerging Bitcoin market. Coinbase offers similar solutions to those of Bitpay. Popular gift-card site Gyft allows users to purchase giftcards using Bitcoin for thousands of different online and brick-and-mortar stores (check them out, there's a good chance you could pay for your groceries/clothes in Bitcoin if you wanted to).

This addition of NPR's Planet Money describes why the simple act of "sending money" electronically is so slow. Basically, the payment processing systems we have in place right now were implemented on an ad-hoc basis, we made slow improvements from the act of "mailing paper checks back and forth" as technology allowed. Unfortunately, this system does a poor job of taking advantage of the conveniences of the internet, with weird quirks like the fact that these automated computers that process payments don't work on weekends. And further, banks have almost no incentive to improve their systems because they earn huge commissions on wire transfers.

Bitcoin on the other hand was designed to scale with technological increases. The distributed network of "miners" who process transactions runs 24/7, and because miners constantly compete to earn the Bitcoin that are created with each block, the system won't be thrown off by changes in technology.

For a transaction to be "confirmed", it generally takes around an hour. However, users can pay a fee to miners, making their transaction look more attractive to process, which typically will get it confirmed even quicker. Keep in mind, this network is global, these times apply to sending money anywhere in the world. Right now, an international transfer using Bitcoin would probably incur transaction fees on both ends ($ -> BTC -> Yuan, for instance) for converting currency. But as the number of merchants that accept Bitcoin increases, so too does the prospect for a world where the recipient of an international Bitcoin transaction can easily spend the Bitcoin she received without having to worry about converting it.

Credit card companies reap huge commissions off the fact merchants are dependent on credit cards to provide a cheap means for consumers to send money electronically. I recently purchased some Eucalyptus Soap from Wholly Hemp using Bitcoin. I was given a 10% discount for using Bitcoin, and the transaction processed within a minute.

The other benefit to the law-abiding Bitcoin user ties into two events that occurred since the Silk Road shutdown that I haven't yet discussed. First, the brinksmanship in the US congress over legislation to raise the debt ceiling (and allow the US government to pay its bills) undermined confidence in both the US dollar and US government bonds. Don't get me wrong, the dollar is the world's reserve currency and that is not going to change any time soon. Likewise, US government bonds are one of the most stable financial assets on the planet, and are often used as hedges by large and small financial institutions alike. But the reverberations of fear from this fiasco won't quickly subside, particularly since we may face the exact same thing on February 7 when the debt ceiling is reinstated. This episode demonstrated a major problem with politicized currency. And when uncertainty over one currency increases, demand for viable alternatives increases. I believe that this time around, people saw Bitcoin as one of those viable alternatives.

Additionally, Baidu, often dubbed "The Google of China" announced shortly after SR's demise that they would be accepting payments in Bitcoin. Certainly at least some of the observed increase in demand for Bitcoin is due to this, which speaks to both to Bitcoin's appeal for established corporations and its appeal in emerging markets. Afterall, transactional demand for Bitcoin accounts for at least some of its value, and this development increases the transactional use of Bitcoin. But to delve a bit deeper, I think the timing is interesting. It's possible that the Silk Road shutdown and Baidu's announcement only lined up by coincidence, but I think there's a very real chance that the two were related. It makes sense for a large company to be apprehensive about becoming associated with a "drug currency", so I think it's possible that Baidu waited until the Silk Road met it's end, so that they could make their announcement at a time when we people were beginning to look at Bitcoin for what it not for how it had been used, but how it could be used.
As with previous Bitcoin price booms, it is near impossible to divorce the effect on the price due to the factors above, from the effect on the price of investors reacting to the factors above. I think it's highly likely that prices are inflated above a middle-term pseudo-equilibrium (by which I mean around 10% variation in either direction, for a couple months), and we'll probably see a downward correction soon. But unlike previous corrections, I think it'll be a modest one, because in my opinion this whole episode with the Silk Road shutdown has served to strengthen faith and spark further enthusiasm over the long term viability of Bitcoin in legitimate markets.

Thursday, October 17, 2013

After a couple requests, here's a copy of my W&L Economics Capstone paper that I wrote about Bitcoin, submitted in May of 2012. Please keep in mind at the time I wrote this I was a senior who's main priority was to get it done, so it's not very polished.

I've been tempted to go back and edit it, but I decided to leave it as it was originally submitted to preserve its historical value, particularly because it contained predictions about where I thought Bitcoin would go. At the time I wrote it, Bitcoin was trading for around $5 per coin (currently it's at $145 per coin on campbx.com).

Friday, October 11, 2013

The Silk Road, an online marketplace that for the past two years facilitated online transactions of elicit goods including drugs, paraphernalia, digital goods, forgeries and many other shady products met its end last week. The feds shut it down, and the alleged founder (after reading the affidavit, I believe Ulbricht is the wrong man, more about that later) is currently being held in super-alcatraz. I read the news early that morning, and immediately did something that I thought would be really clever. I did what I did because I believed 2 things:

First, those of you who have been following Bitcoin probably know that the Silk Road was in many ways responsible for the early viability of Bitcoin. The website, which operated on the tor network only allowed transactions of things like marijuana, cocaine, ecstacy, psychadelics, pornography, fake IDs, etc. to take place in Bitcoin. Hundreds of millions of dollars worth of Bitcoin moved through the marketplace. For a long time, the Silk Road was a major part of the burning question enshrouding Bitcoin: fiat currencies are only as valuable as the goods and services one can trade them in for, and the Silk Road allowed users to trade Bitcoin for things they couldn't get anywhere else online. Even early adopters of Bitcoin like me had to acknowledged that for all of its legitimate applications, in the short term Bitcoin needed the Silk Road to survive and be taken seriously.

The image below is from presentation for my senior economics capstone on Bitcoin that I turned in early May of 2012.

The top chart shows the intra-daily price variance in Bitcoin (daily change in price), and the bottom shows the search density of the term "silk road'+Bitcoin" according to Google Trends. My intuition was that as the popularity of the Silk Road grew, interest in Bitcoin would grow as well, and that the Silk Road may have been responsible for the huge spike in price.

Even after the period in 2011 that this data covers, the Silk Road remained both a large player in the Bitcoin economy, and a common association for Bitcoin amongst those who sought to celebrate or demonize the currency.

Second, the early 2013 spike and crash in the price of Bitcoin showed that Bitcoin investors are a skittish bunch. Most Bitcoin followers knew that with the level of growth Bitcoin had enjoyed throughout early 2013, a correction was inevitable, but the severity of the correction had a lot of people thinking it was a collapse. The tumbling effect was clear, novice investors saw the initial drop (which was partially manufactured by directed attacks against exchange sites), and reacted to it thinking that the Bitcoin dream was over, and sold off their holdings, causing further drops. I held onto my coin through it, and across 2013 was still way ahead for it, but the episode illustrated that the market is still vulnerable to panic sell-offs.

And so, when I saw the news about the Silk Road biting the dust, it seemed obvious to sell off some of my Bitcoin in advance of the panic sell-off, and buy more at the trough. Clever, right? I mean, Bitcoin enthusiasts can insist all day that Bitcoin is more than a drug currency, but at present it's still dependent on it, right?

And even if the Silk Road seizure doesn't have an effect, the novice investors will react thinking it will, and the price will drop anyways. And this one could be severe, part of the reason people held Bitcoin through the first cash is that they knew it still had applications to buy goods and services. Selling seemed like a no-brainer.

I sold a few of my most liquid Bitcoins, the coins that happened to be sitting around on campbx.com and not in an offline wallet, at about $122. The chart below shows what happened to the price of Bitcoin in the ensuing days:

I bought a few coins when it was down near $100 (about half of what I sold off), and waited to see what happened from there. The result? Bitcoin is trading about $5 higher on CampBX today than it was before the Silk Road shut down.

If I had simply held my Bitcoin throughout the whole thing, I would have come out ahead by a few dollars. So much for my clever idea. Of note in the above chart, is that each sell-off didn't seem to beget more selling-off. The market didn't hit any kind of downward spiral like it did back in April, there were solid corrections in the opposite direction associated with every drop.

I think the memory of the last collapse may have contributed to the stability this time around. Last time every media outlet that had even mentioned Bitcoin in the past was tripping over itself to get the word out about the "Bubble bursting." It was a great story for them, a bunch of people poured their money into a glorified ponzy scheme and now it was all coming down. Money, confusing computerish thing, cautionary tale, check check check, journalistic gold.

However, Bitcoin was reluctant to play its role in that narrative. After the panic sell-off in April, some people thought Bitcoin was done for, they thought it better to sell their Bitcoin at $50 than to wait for it to hit zero. The prices discussed above show why that was a misguided strategy. A combination of long-term believers in Bitcoin holding onto their investments, and continued purchases of Bitcoin in order to buy goods (on the Silk Road and elsewhere) helped Bitcoin weather the storm.

So when post-Silk Road drop happened, Bitcoin investors weren't as quick to panic. The sky wasn't falling, it was just a little drizzle. I think this demonstrates the relative maturity of Bitcoin investors now, compared to 6 short months ago, in part because the panic sellers stayed out for good after last time, and also because those of us on the fence were reassured by the last rebound. At every trough on the chart above, there were enough people who saw an opportunity to buy back in.

But there's more to it than that. The fallout from the federal takedown of the Silk Road showed that it was more than just a website, it was a proof of concept, and at least for a while, it worked.

For one, most agree that Road founder Dread Pirate Roberts was taken down for his sloppiness. He was caught importing fake IDs from Canada that he allegedly planned to use to rent servers. It's a bit puzzling why he would import IDs and risk customs catching his illegal shipment (which they eventually did) when the Silk Road itself has US based sellers that also offered fraudulent identification.

Also, the Silk Road heavily encouraged customers and sellers to use PGP Encryption (the kind that at current computing standards would take a few millennia to decrypt without the password) to protect personal information, yet DPR allegedly left a mountain of evidence in plain-text messages including a request to have a Silk Road user assassinated. This level of sloppiness is why in part I believe Ulbricht may have been set up, but either way I think it's fair to say that even if the downfall of the Road was inevitable, this particular plague was avoidable.

And apart from Ulbricht, the fall-out seems pretty minimal. About $80 million worth of Bitcoin in user accounts is rumored to be hidden somewhere, but it doesn't look like many people will be going to jail over this.

More importantly, as a concept the Silk Road has certainly survived past its first iteration. This thread on the Silk Road Forums (.onion links only work through Tor browser) contains 17 pages worth of posts from former Silk Road vendors informing their customers of other websites where they will continue operations. Almost all of them are headed to either Sheep Marketplace or Black Market Reloaded, two former competitors of the Silk Road that are now tasked with becoming its successors.

It remains to be seen if Sheep or BMR can not only satisfy the demand for services that Silk Road met, but also improve upon its architecture to reduce the possibility of another takedown and seizure of funds. Part of the genius of Silk Road was in its tumbling/washing service. Recall that all Bitcoin transactions that ever occur are added to a long ledger called the blockchain, which keeps track of how many coins each wallet has available to spend. Generally, it's very easy to find out where the Bitcoin in a wallet came from. The tumbling service protected sellers by masking and obscuring the path of Bitcoin through the network, so that it wouldn't be clear to either party where the Bitcoin started and where they eventually ended up.

Beyond tumbling, there are other challenges that these spiritual SR-successors will have to meet, including robust enough security to withstand the inevitable onslaught of hacking attacks. But I think the fact that so many sellers have continued operations elsewhere showed that taking down one website was merely a battle in what is bound to be an enduring war.

So Bitcoin has recovered from the minor setback that the Silk Road shutdown created. Going forward, I think with the increasing maturity of the average Bitcoin investor, shocks like this will continue to decrease in severity. Further, the fact that the Silk Road concept, a major market application for Bitcoin has managed to live beyond its most successful implementation thus far does a great deal to assuage the fears of those that believe Bitcoin will one day suffer from regulatory pressure.

In light of the recent press coverage #Bitcoin has been getting, I thought I'd make a quick blogpost on the subject.

If you've somehow managed to avoid my Bitcoin spiel in person, Bitcoin is an anonymous, decentralized cryptocurrency. Think online cash, it's not backed by any government, floats relative to other currencies, and once you have bitcoin you can spend them completely anonymously.

I was motivated to make this post in light of the tone the news takes when they discuss Bitcoin. Bitcoin traded at about $13 per bitcoin in early january, as I write this it's trading at $137 per bitcoin. This meteoric rise has given the talking heads all they need to call this a "bubble."

So is it this all a speculative bubble? Yes, but not in the way that you think.

In the short term, what we're seeing with the price of Bitcoin is absolutely a speculative bubble. By speculative bubble, I mean that people are buying Bitcoin solely in the hopes that it will appreciate relative to the dollar or euro, and that they will be able to sell their coins for more money later. In this regard, the media are correct. Many people are just hearing about Bitcoin now, they're nervously watching the EU struggle to secure long term monetary stability, and they see Bitcoin as the perfect way out.

Now, Bitcoin aren't tied to any real world thing, they are only as valuable as the amount of money people are willing to part with to obtain them, or as valuable as the goods and services that people can buy with them. If most of the demand for Bitcoin right now is speculative (and there's a lot of evidence for this), then eventually speculators are going to want to cash out some of that Bitcoin, which could easily cause a run and make the value of Bitcoin plummet.

So why, you might ask, do I still have money invested in Bitcoin when I know this bubble isn't sustainable and the value will eventually crash? I'm sticking with Bitcoin because we've only seen the tip of the iceberg for Bitcoin's potential.

While speculation can cause short-term spikes in the price of a financial asset, transactional use is the enduring source of value for any currency. Dollars have value because you can spend them in exchange for goods and services. If people stopped accepting dollars, they would be worthless.

Merchants are only just now starting to discover the merits of Bitcoin for their businesses. Companies like BitPay offer solutions where customers can pay in Bitcoin, and the merchant will receive the equivalent dollar amount immediately, without having to worry about Bitcoin price volatility. With these kinds of services, it's only a matter of time before the gym or coffee shop down the street from you lets you pay in Bitcoin too.

Bitcoin payment processors offer fees comparable to or lower than those of credit card companies. Billions of dollars are lost annually in credit card charge backs, and the credit companies predicate their business model on encouraging American's to take on unmanageable debt. Bitcoin allows users and merchants to exchange digital money without supporting these credit card companies and propping up the cycle of predatory debt.

In its early days, Bitcoin mainly received attention for it's discrete exchange applications, as websites like The Silk Road allowed users to exchange Bitcoin for drugs, counterfeits, and other illegal goods and services. Last month however, BitPay, a service that only deals with legitimately recognized businesses facilitated more Bitcoin transactions than The Silk Road. The black market uses for Bitcoin still remain, but BitPay's shows that Bitcoin has just as much potential for legal purchases. We ought to give Bitcoin the chance to shake off it's association with illegal activity, as it's no more deserving of said association than cash.

I really think Bitcoin could be the socially responsible, easy and anonymous currency of the future. It's an outlet for those weary of large financial institutions, be they national banks or private investment leviathans, and it carries appeal for socialists and crypto-anarchists alike. By itself it's rough and far too complex for most people, but in a free market we're sure to see new businesses pop up to bridge the technological divide, and make Bitcoin accessible even for a lay-user.

Right now, the $137 price tag for a Bitcoin is mostly based on speculation. It will probably grow for the next few weeks, maybe few months, but eventually speculators will realize they've had enough and they'll pull out. This may or may not cause a downward spiral in prices as investors react to the signal and cash out their own holdings.

But, a crash doesn't mean the end of Bitcoin. Like I said, the long term value of Bitcoin lies in it's potential to buy goods and services. Speculators will come and go but as more people start trading in Bitcoin, whether it's to split up a bar tab, donate to their favorite website, purchase illegal goods, gamble online, or just buy a cup of coffee, the market will thicken and grow resistant to the whims of sentimental investors trying to make a quick buck.

I don't mean to speak in overly certain terms about Bitcoin's future. The preceding is based on my limited knowledge of Economics and of the Bitcoin market, and doesn't even begin to address the technical issues with scaling or the potential for government regulation. I won't pretend to know exactly where the future of Bitcoin is heading, but what I do know for sure is this crazy ride is only just beginning.